Supreme Court Clarifies Taxability of Non-Compete Fees: Shiv Raj Gupta vs. Commissioner of Income-Tax (2020)

Date of the Judgment: 22nd July, 2020
Citation: [Not Available in Source]
Judges: R.F. Nariman, J., Navin Sinha, J., B.R. Gavai, J.

Can a payment received for agreeing not to compete with a business be taxed as business income, or is it considered a capital receipt? The Supreme Court of India recently addressed this question in a case involving a former managing director who received a substantial sum for a non-compete agreement. This judgment clarifies the tax implications of such payments, providing crucial guidance for businesses and individuals involved in similar transactions. The bench comprised of Justices R.F. Nariman, Navin Sinha, and B.R. Gavai.

Case Background

The case revolves around Shri Shiv Raj Gupta, the former Chairman and Managing Director of M/s Central Distillery and Breweries Ltd. (CDBL). In 1994, Mr. Gupta and his family held a majority stake (57.29%) in CDBL. On April 13, 1994, Mr. Gupta entered into a Memorandum of Understanding (MoU) with three companies of the Shaw Wallace Company (SWC) group to sell his controlling shares.

As part of the agreement, Mr. Gupta received ₹55,83,270 for his shares and ₹6,60,00,000 as a non-competition fee through a separate Deed of Covenant. This deed restricted Mr. Gupta from engaging in any business related to Indian Made Foreign Liquor (IMFL) or beer for ten years. The core dispute is whether this ₹6.6 crore payment is a non-compete fee or compensation for terminating his management, which would be taxable under Section 28(ii)(a) of the Income Tax Act, 1961.

Timeline:

Course of Proceedings

The Assessing Officer (AO) determined that the ₹6.6 crore payment was not genuinely for a non-compete agreement but was a device to evade tax under Section 28(ii)(a) of the Income Tax Act, 1961. The AO noted that Mr. Gupta’s other business, M/s Maltings Ltd., was not a significant competitor to SWC, and no such fee was paid to his son who also resigned from a managerial position.

The Commissioner of Income Tax (Appeals) upheld the AO’s decision. However, the Income Tax Appellate Tribunal (ITAT) had a split decision. The Accountant Member favored the assessee, stating the deeds should be read separately and there was no tax evasion. Conversely, the Judicial Member sided with the AO. A third Judicial Member was appointed, who sided with the Accountant Member, leading to a 2:1 majority in favor of the assessee. The revenue then appealed to the High Court.

Legal Framework

The core legal provision in this case is Section 28(ii)(a) of the Income Tax Act, 1961. This section states:

“28. Profits and gains of business or profession. The following income shall be chargeable to income-tax under the head “Profits and gains of business or profession”, – xxx xxx xxx (ii) any compensation or other payment due to or received by, – (a) any person, by whatever name called, managing the whole or substantially the whole of the affairs of an Indian company, at or in connection with the termination of his management or the modification of the terms and conditions relating thereto;”

This provision taxes compensation received by a person managing a company upon termination of their management. The dispute was whether the non-compete fee was, in reality, compensation for termination of management, which would make it taxable under this section.

Arguments

Appellant’s Arguments:

• The appellant argued that the High Court overstepped its jurisdiction by addressing a taxability issue beyond the substantial question of law framed.
• The appellant contended that the non-compete fee was a separate transaction, supported by the Deed of Covenant, and should not be taxed under Section 28(ii)(a) of the Income Tax Act, 1961.
• Relying on the judgments of the Accountant Member and the third Member of the ITAT, the appellant argued that the revenue cannot challenge the business perception of the assessee and that there was no colourable device involved.
• The appellant cited that prior to 01.04.2003, amounts received for not carrying out business activities were not taxable under Section 28(va) of the Income Tax Act, 1961, and that this provision is not retrospective.

Revenue’s Arguments:

• The revenue argued that the High Court correctly applied McDowell & Co. Ltd. v. CTO (1985) 3 SCC 230 and Vodafone International Holdings BV v. Union of India (2012) 6 SCC 613, stating the non-compete fee was a sham to avoid tax.
• The revenue contended that the amount was essentially payment for the sale of shares and the transfer of management control.
• The revenue argued that the payment should be taxed under Section 28 (ii)(a) of the Income Tax Act, 1961, as it was compensation for the termination of management.

The innovativeness of the argument by the appellant lies in highlighting the separate nature of the non-compete agreement and its treatment as a capital receipt prior to the introduction of Section 28(va), while the revenue’s argument focused on the substance over form principle, suggesting the non-compete fee was a disguised payment for the sale of shares and termination of management.

Submissions of Parties

Issues Framed by the Supreme Court

The Supreme Court did not explicitly frame issues in a separate section, but the core issue was:

1. Whether the High Court was correct in holding that the amount of ₹6.6 crores received by the assessee was taxable as capital gains, when the substantial question of law framed was only regarding the applicability of Section 28(ii)(a) of the Income Tax Act, 1961.
2. Whether the non-compete fee of ₹6.6 crores received by the appellant is taxable under Section 28(ii)(a) of the Income Tax Act, 1961, or is a capital receipt.

Treatment of the Issue by the Court

Authorities

Cases Cited by the Court:

Legal Provisions Considered by the Court:

Judgment

How each submission made by the Parties was treated by the Court?

How each authority was viewed by the Court?

• Kshitish Chandra Purkait v. Santosh Kumar Purkait [(1997) 5 SCC 438]: The court followed this authority to emphasize the duty of the High Court to formulate substantial questions of law.
• Dnyanoba Bhaurao Shemade v. Maroti Bhaurao Marnor [(1999) 2 SCC 471]: The court followed this authority to reinforce the principles laid down in Kshitish Chandra Purkait regarding the High Court’s duty to formulate substantial questions of law.
• Biswanath Ghosh v. Gobinda Ghosh [(2014) 11 SCC 605]: The court followed this authority to reiterate the principles for second appeals, emphasizing that the High Court must formulate and address substantial questions of law.
• CIT v. Walchand & Co. [(1967) 3 SCR 214]: The court followed this authority to establish that the reasonableness of expenditure must be judged from the point of view of the businessman, not the revenue.
• J.K. Woollen Manufacturers v. CIT [(1969) 1 SCR 525]: The court followed this authority to reinforce the principle that the Income Tax Department cannot determine the remuneration to be paid to an employee.
• CIT v. Panipat Woollen & General Mills Co. Ltd. [(1976) 2 SCC 5]: The court followed this authority to reiterate that the test of commercial expediency must be judged from the point of view of the businessman.
• Shahzada Nand & Sons v. CIT [(1977) 3 SCC 432]: The court followed this authority to emphasize that factors must be considered from the point of view of a normal, prudent businessman and not the subjective standard of the assessing authority.
• S.A. Builders Ltd. v. CIT [(2007) 1 SCC 781]: The court followed this authority to state that the revenue cannot put itself in the armchair of the businessman and decide what is a reasonable expenditure.
• Hero Cycles (P) Ltd. v. CIT [(2015) 16 SCC 359]: The court followed this authority to reiterate that the expression ‘for the purpose of business’ is wider than ‘for the purpose of earning profits’.
• Guffic Chem (P) Ltd. v. CIT [(2011) 4 SCC 254]: The court followed this authority to differentiate between compensation for loss of agency (revenue receipt) and compensation for a negative covenant (capital receipt).
• Gillanders case [(1964) 53 ITR 283 (SC)]: The court followed this authority to establish the dichotomy between compensation for loss of agency and compensation for a negative covenant.
• CIT v. Rai Bahadur Jairam Valji [(1959) 35 ITR 148 (SC)]: The court followed this authority to state that compensation received for termination of a contract in the ordinary course of business is a revenue receipt.

What weighed in the mind of the Court?

The Supreme Court’s decision was primarily influenced by the principle that the revenue cannot second-guess the commercial decisions of a business. The court emphasized that the non-compete fee was a separate agreement, supported by a Deed of Covenant, and that the amount was determined through negotiations between the parties. The court also noted that the High Court had exceeded its jurisdiction by addressing a taxability issue beyond the framed question of law.

The court’s reasoning was heavily based on legal principles and precedents, with a moderate consideration of the factual aspects of the case.

The court considered alternative interpretations, such as the revenue’s claim that the non-compete fee was a sham to avoid tax, but rejected them. The court emphasized that the revenue cannot second-guess the commercial decisions of a business.

The court’s decision was that the non-compete fee of ₹6.6 crores was a capital receipt and not taxable under Section 28(ii)(a) of the Income Tax Act, 1961. The court held that the High Court had exceeded its jurisdiction by addressing a taxability issue beyond the framed question of law.

The court’s reasoning was based on the following points:

• The High Court exceeded its jurisdiction by addressing a taxability issue beyond the framed question of law.
• The non-compete fee was a separate transaction, supported by the Deed of Covenant.
• The revenue cannot second-guess the commercial expediency of the transaction.
• The amount was determined through negotiations between the parties.
• The non-compete fee was a capital receipt and not taxable under Section 28(ii)(a).

The court did not have a minority opinion.

The court’s decision has implications for future cases involving non-compete agreements, clarifying that such fees are generally treated as capital receipts unless there is clear evidence of a sham transaction.

The court reiterated the principle that the revenue cannot put itself in the armchair of the businessman and decide what is a reasonable expenditure.

The court did not introduce any new doctrines or legal principles but reinforced existing principles of commercial expediency and the treatment of non-compete fees as capital receipts.

Key Takeaways

• Non-compete fees received under a separate agreement are generally treated as capital receipts and not as business income.
• The revenue authorities cannot second-guess the commercial decisions of a business.
• The High Court’s jurisdiction is limited to the substantial questions of law framed in the appeal.
• The principle of commercial expediency should be judged from the viewpoint of a businessman and not the revenue.
• This judgment clarifies the tax implications of non-compete agreements, providing guidance for businesses and individuals.

Directions

No specific directions were given by the Supreme Court in this judgment.

Specific Amendments Analysis

There was no specific amendment analysis done by the Court in the judgment.

Development of Law

The ratio decidendi of the case is that a non-compete fee received under a separate agreement is generally treated as a capital receipt and not as business income taxable under Section 28(ii)(a) of the Income Tax Act, 1961. This judgment reinforces the principle that the revenue cannot second-guess the commercial decisions of a business. There is no change in the previous position of law, but a clarification of existing principles.

Conclusion

The Supreme Court set aside the Delhi High Court’s judgment, holding that the non-compete fee of ₹6.6 crores received by Shri Shiv Raj Gupta was a capital receipt and not taxable under Section 28(ii)(a) of the Income Tax Act, 1961. The court emphasized that the revenue cannot second-guess the commercial decisions of a business and that the High Court had exceeded its jurisdiction by addressing a taxability issue beyond the framed question of law. This judgment clarifies the tax implications of non-compete agreements, providing crucial guidance for businesses and individuals involved in similar transactions.